Friday, April 29, 2011

Bought Wells Fargo at 28.74

This transaction makes about 5% of my portfolio.

Here are the reasons for the purchase
  1. One of the best managements in the banking industry.
  2. Banking normally is a very good business with high returns on equity and high free cash flow payout rates(generally >50%)
  3. Its also one of the riskiest businesses because of leverage involved and hence its very important that you bet on the right jockey.
  4. Wells Fargo is trading at a reasonable 12x free cash flow and 1.2x book value.
  5. Historically the bank has commanded a premium price compared to other banks. Historically it trades at around 15x earnings and 2.7x book value. 
  6. Historically WFC has had Return on Equity around 19% while currently the return on equity is at 10%. This is because of two reasons .....1) Wells Fargo(like other banks) have solidified their balance sheet in past few years raising equity by withholding dividends and issuing stocks 2) The loan volume is quite anemic because of depressed US economy......and hence their earnings are depressed. I expect that someday the housing crisis will end and home loan issuance will return to the new normal level ( lower than the historical normal)
  7. The loans Wells is underwriting at present are much more profitable and low risk
  8. As interest rates go up Wells will be able to earn more on the excess cash on balance sheet(the one its not able/willing to lend currently)
 The above summary is all just guesswork based on historical data and from my gut feeling about Wells business. Financial companies are always too difficult to analyze and there is always a risk that you have missed something.But they are also very profitable and generally they benefit from inflation. So one way to invest in financial companies is to bet on the lowest risk and most well managed institution even though you may have to settle with lower returns. That's what a bet on Wells Fargo is in my opinion.

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